Inflation risk worries investors

The yield on the 30-year US Treasury bond rose to a record 1.45 percentage points over the 10-year bond last week, investors ditching the long term bellwether as inflation expectations soar. That’s bad news for investors hoping that the next round of quantitative easing by the US Federal Reserve will help bolster the flailing US economy.

Given that most mortgages are priced off the 30-year bond rate the Fed would want the yield falling, not rising. At about 4 per cent it’s at its highest yield in about two months. Making bond investors nervous are the rising expectations for inflation over the next 10 years that have surged to 2.17 per cent from 1.80 per cent since the start of October.

As the Fed inflates the economy to get it working the risk of putting up with a period of high inflation concerns the bond market. The risk is that as the Fed prints money to push inflation higher, long-term bond yields could spike higher and oil prices could also rise sharply, putting the brakes on any sustained recovery in the economy.

October might be known as the witching month for stocks but it hasn’t stopped Deutsche Bank calling for further gains for the local market. The major S&P/ASX 200 Index is still up about 2 per cent so far this month, despite yesterday’s sell-off, and the broker reckons that by the end of the year it will be 4950, up from Monday’s closing level of 4651.9.

There’s more good news for investors as the broker reckons by mid-2011 the index will be at 5400.

The broker is also bullish on the outlook for US stocks and thinks our market will follow suit. The S&P 500 has been dragged down over the past six months by European debt worries and the ailing US economy, but Deutsche Bank reckons the market has bottomed out and with the prospect of a double-dip recession receding investor sentiment has improved and a price-earnings re-rating is on the cards.

That better outlook should flow through to local stocks. Their forecasts depend on earnings forecasts remaining stable but the broker is confident there will also be re-rating of the local P/E in the coming months with a more substantial re-rate next year.

Analyst Tim Baker sees the P/E of the market rising from its current level of about 11 to 12 times earnings to above 13 times, still well below its long-term average of about 15 times. The Australian dollar is seen as a problem for companies that get a fair share of revenue offshore but that is offset by resource companies that have a good chance of announcing an upgrade to their earnings.

■ ■ ■ ■ ■Star-struck by the Australian dollar’s rise to parity, many investors are looking to jump into currency markets in a search for trading profits as an alternative to stocks. It’s been one way traffic in the dollar since June, rising about 25 per cent against the greenback.

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But trading currencies is a very risky business. Investors are taking on two risks for a start, buying one currency and selling another.

In the US, the Commodity Futures Trading Commission has framed a new batch of rules designed to protect investors. The new rules kicked off overnight and will stop dealers from gearing up too much on major currencies such as the US dollar and the yen. Trading in currencies has been popular this year and brokers have been quick to react. Earlier this year, Forex.com launched a new pricing structure that cut the cost of trading by half.

Currency movements can diversify your portfolio away from stocks and bonds but they can also move around on a range of factors, including changes in interest rate expectations.

Earlier this month the dollar slumped about US1¢ when the Reserve Bank of Australia kept rates at 4.5 per cent when expectations were high that the official cash rate would rise to 4.75 per cent. That sort of move is common. According to the RBA, the daily long-term average intra-day move in the dollar is about US0.75¢. When the financial crisis was in full swing the dollar was moving by more than US3.5¢ a day.